China and the yuan: What's at stake

By Chris Isidore, senior writerApril 12, 2010: 11:44 AM ET

NEW YORK (CNNMoney.com) -- Chinese and U.S. officials are reportedly close to a deal on boosting the value of China's currency, the yuan -- the first step to making U.S.-made goods more competitive versus Chinese exports.

U.S. Treasury Secretary Timothy Geithner was in China for a surprise meeting last week, and Chinese President Hu Jintao arrived in Washington on Monday to attend a global conference on nuclear security.

The agreement is widely expected to result in an immediate 2% to 3% rise in the yuan -- a fairly modest step. What could make the agreement significant, however, is if China agrees to future increases as the currency moves toward being freely traded for the first time.

Laidi thinks the yuan is undervalued by 15% to 20%, and said a rise of 6% to 7% a year will be needed to start to make a significant dent in the undervaluation.

That's possible, Laidi said, given that China allowed the yuan to rise more than 15% from mid-2005 to mid-2008.

Some economists think the yuan is undervalued by as much as 40%. But many said there is good reason for both China and the United States to pursue a slow adjustment.

A rapid change, they say, would risk of inflating an asset bubble in China, followed by a bust that could cause problems throughout the global financial system.

"The movement from managed currency to freely floating currency is not easy to pull off," said Mark Vitner, senior economist with Wells Fargo Securities. "If we have a boom and then a bust in China, that could lead to another global recession."

But critics of the value of the Chinese yuan today dismiss those worries. The artificially low value of the yuan is causing problems of its own, they say, including an overheating Chinese economy and a big trade gap between the United States and China.

"There's going to be a hangover from years of having the yuan grossly undervalued," said University of Maryland Professor Peter Morici. "The more the patient drinks, the worse the hangover will be unless the patient eventually passes out and dies."

Morici is a harsh critic of both the Bush and Obama administrations for not pushing the Chinese more. He advocates threatening China with steep tax penalties to force the issue.

"Unemployment would be falling rapidly and the U.S. economy recovering more rapidly but for the trade deficit with China and Beijing's currency policies," Morici said.

Risks of a stronger yuan

While a stronger yuan -- and a weaker dollar -- is widely considered to be a good thing for U.S. manufacturers, some experts say it won't be accomplished without some problems for Americans.

Much of the nearly $300 billion in Chinese exports annually are not going to suddenly start being produced at U.S. factories simply because of a rise in the value of the yuan. Labor costs are still going to be lower in China, and environmental and safety regulations will not be as strict.

"The labor-intensive parts of the manufacturing base that have been lost here are never coming back," said Vitner.

Instead, the higher yuan will mean Chinese products will become more expensive for U.S. consumers.

In addition, China has been keeping the yuan cheap by buying massive amounts of U.S. dollars and Treasurys.

Let the yuan float free and China won't need to buy as much. And that could mean higher interest rates on U.S. Treasurys, and thus higher borrowing costs for many U.S. homeowners and businesses.

It also could lead to a slide in the value of the dollar, which in turn could raise the price of imports from elsewhere in the globe, such as oil.

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